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Pokemon Go Shows Why GameStop Corp. Is Doomed

The video game retailer is unable to cash in on the wildly popular mobile game.

Shares of Nintendo(NASDAQOTH:NTDOY) have more than doubled in the last month, as the mobile game's viral success has prompted some investors to make optimistic bets on the video game giant's future. But Nintendo shareholders aren't the only investors benefiting -- shares of video game retailer GameStop(NYSE:GME) are surging in the wake of Pokemon Go's release. GameStop shares rose nearly 8% on Monday after CEO Paul Raines told CNBC that sales at some GameStop locations have more than doubled within the last few weeks.

Although Pokemon Go may benefit GameStop shareholders in the very near-term, the game's success is quite negative for the company overall. By itself, Pokemon Go won't devastate GameStop, but it speaks to trends undermining the retailer's business model.

Digital, mobile, and free-to-play

Pokemon has been one of Nintendo's most successful video game franchises since the original Pokemon Red and Pokemon Blue went on sale in Japan back in 1996. The series has been adapted into many other forms of media (most notably a cartoon and collectible card game) but has always stayed true to its video game roots. Over the last 20 years, more than two dozen different Pokemon video games have been released across a wide variety of Nintendo devices. Later this year, owners of Nintendo's 3DS handheld will be able to play the latest installments, Pokemon Sun and Pokemon Moon.

Pokemon Go is yet another game in the long-running series, but it represents a fairly dramatic break from the traditional formula. Obviously, Pokemon Go centers around a particularly unique gameplay mechanic: Using augmented reality, players are encouraged to interact with the real world in order to progress in the game. But Pokemon Go is just as notable for its unique business model.

In the past, Nintendo asked its fans to spend upwards of $40 to play each of the various Pokemon titles, which have generally been released on cartridges, discs, or as full-game downloads for its various video game consoles. With Pokemon Go, however, Nintendo is asking for nothing upfront: The game is entirely free to play. Gamers can spend hundreds, or even thousands of hours playing Pokemon Go without giving Nintendo a dime.

And yet, currently, Pokemon Go is the top-grossing app on the iTunes App Store according to App Annie, ahead of popular subscription service Spotify. Like other free-to-play mobile games, Pokemon Go offers its players the ability to swap real money for in-game currency. Pokemon Go's currency, PokeCoins, are sold in various bundles -- for example, gamers can snag 2,500 PokeCoins for $19.99. Those PokeCoins can be used to purchase in-game virtual items, including Poke Balls (used for catching additional Pokemon) and incense (used for attracting new Pokemon to your location).

At this point, it's a well-established business model, one that other mobile game creators have ridden to tremendous success. In 2014, at the height of its popularity, Candy Crush Saga players spent over $1.3 billion on in-app purchases. It's hard to tell if Pokemon Go will have the staying power of Candy Crush (it remains a top grossing app to this day), but if it does, it could generate as much or more revenue from its fans over time.

That's great news for Nintendo, but it's problematic for GameStop.

There's no margin for GameStop

For nearly 20 years, GameStop has participated in the Pokemon craze, working as an intermediary between Nintendo and its players. In 2007, for example, Nintendo released Pokemon Diamond and Pokemon Pearl for its then wildly popular handheld console, the Nintendo DS. If a gamer chose to purchase these games from GameStop, the retailer took a cut of the sale, about 20%. If the gamer was buying a Nintendo DS in order to play them, even better, with GameStop generating even more revenue at the point of sale. After a year, that same customer may grow tired of the game and trade it to GameStop to buy a different version of Pokemon. GameStop can then turn around and sell that pre-owned game to a different player, reaping a large profit in the process.

GameStop derives the overwhelming majority of its revenue in this fashion, with most sales coming from physical video game products, notably discs and consoles. Video game hardware, software, used video games, and accessories made up about 80% of its revenue and 70% of its gross profit last quarter.

But GameStop isn't a major player in the market for mobile games, as there's simply no role for the company to play in the transaction (to be fair, GameStop publishes some mobile games of its own through a subsidiary, Kongregate, but it's an insignificant driver of its financials). Instead, Apple and Google work as intermediaries, taking a cut of the revenue that games distributed through their respective digital stores generate.

With Pokemon Go, there's no disc or cartridge for GameStop to sell in its stores. There's no console to be purchased, as the game is played on smartphones and tablets. There are no extra controllers or memory cards to buy. GameStop does sell smartphones, smartphone accessories, and collectibles, including Pokemon merchandise, all of which may see increased demand with the success of Pokemon Go. However, they generate a relatively small percentage of the company's revenue (about 14% last quarter).

Mobile gaming is a recent phenomenon, spurned on by the ubiquity of the smartphone and the app store distribution model. Mobile gaming generated just $4.7 billion in 2009. That rose to $34.8 billion in 2015, and by some estimates, could top $70 billion by 2020. Meanwhile, GameStop's annual revenue has remained roughly unchanged over the last five years. GameStop shares have risen over that time, and the company has paid a rich dividend, but the emergence of mobile gaming seems to have done almost nothing to benefit GameStop's business.

A shift to mobile will benefit Nintendo, but it will mean GameStop carries fewer products

Pokemon Go encourages players to visit PokeStops and Gyms -- real-world locations that are featured within the game. Some GameStop stores are PokeStops or Gyms, and according to Raines, those stores have seen their sales approximately double following the game's release. That might result in GameStop turning in better-than-expected earnings this quarter. The general buzz around Pokemon might also propel sales of Pokemon Sun and Pokemon Moon, and GameStop will sell both games in its stores later this year.

But gamers have limited free time, and Nintendo has only so many employees. Some gamers may skip Pokemon Sun and Pokemon Moon entirely for the mobile experience, while Nintendo may dedicate more resources to the development of other mobile products, taking manpower away from traditional console games, which, in the long run, could result in GameStop having fewer games on its shelves.

GameStop shares are down more than 20% since I warned investors of the company's many problems back in Jan. 2014. I continue to believe the company faces significant challenges, as its industry increasingly shifts away from physical storefronts. Pokemon Go is only one game, but it embodies many of these trends. Rather than invest in GameStop, shareholders may consider using this rally to exit their position.